The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Saturday, June 29, 2013

Opacity allows derivatives to be used for deception

In his NY Times column, Floyd Norris looked at how Italy used derivatives to hide the true size of its budget deficits (something that Greece also did).

The reason that Italy could do this is because derivatives are opaque. Neither the government nor the bank counter-party have to disclose the derivative and its terms.

Derivatives are not always “financial weapons of mass destruction,” as Warren Buffett famously called them.

But they are often weapons of mass deception.

For some derivatives, a desire for deception is the only reason they exist. That deception can allow those who own derivatives to evade taxes or accounting rules. It can allow activity that might otherwise be illegal, were it not called a derivative, or that would face regulation if it were labeled what it truly is.

Sometimes, banks use derivatives they create to help their clients deceive the public. Other times, they enable the banks to deceive those clients.

Please re-read the highlighted text while recalling that all of this is made possible because derivatives are deliberately opaque.

The latest revelation of deception by derivative came in Italian government documents leaked this week to two European newspapers, La Repubblica and The Financial Times.

The Financial Times said it appeared that Italy had used derivatives in the 1990s to allow it to make its budget deficit seem smaller, thus enabling it to qualify for admission to the euro zone. The report said it appeared those derivatives, now restructured, might be exposing Italy to a loss of 8 billion euros ($10.4 billion).

La Repubblica noted that the director general of the Italian Treasury Department at the time, Mario Draghi, is now running the European Central Bank.

Italy’s economy minister, Fabrizio Saccomanni, said it was “absolutely baseless” to say that the country used derivatives to lie its way into the euro zone. ...

What seems to have happened in Italy is similar to something that we already know Greece did. Rather than borrow money — which would increase the reported budget deficit — the country entered into a derivatives contract that called for the banks to make large upfront payments in return for larger payments later from the government.

And how did that differ from a loan? Functionally, not very much, in all probability. But if you call something a derivative you can often get away with keeping it off your balance sheet — or putting it on the balance sheet in a misleading way....

Calling something a derivative can help a company get around inconvenient laws and regulations. ....

The current accounting rules in the United States go so far as to say that banks can hide obligations that are classified as derivatives.

Your humble blogger wonders what percentage of derivative transactions would go away if transparency was brought to this corner of the financial system.

Transparency that should be part of banks disclosing on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.